Week 6 - Final Assignment Integrative Literatu.docx

Week 6 - Final
Assignment
Integrative Literature
Review
A special report on financial risk l February 13th 2010
The gods strike back
RISk.indd 1 2/2/10 13:08:02
The Economist February 13th 2010 A special report on
�nancial risk 1
Financial risk got ahead of the world’s ability to manage it.
Matthew Valencia asks if it can be tamed again
ed by larger balance sheets and greater le-
verage (borrowing), risk was being capped
by a technological shift.
There was something self-serving
about this. The more that risk could be cali-

brated, the greater the opportunity to turn
debt into securities that could be sold or
held in trading books, with lower capital
charges than regular loans. Regulators ac-
cepted this, arguing that the �great moder-
ation� had subdued macroeconomic dan-
gers and that securitisation had chopped
up individual �rms’ risks into manageable
lumps. This faith in the new, technology-
driven order was re�ected in the Basel 2
bank-capital rules, which relied heavily on
the banks’ internal models.
There were bumps along the way, such
as the near-collapse of Long-Term Capital
Management (LTCM), a hedge fund, and
the dotcom bust, but each time markets re-
covered relatively quickly. Banks grew
cocky. But that sense of security was de-
stroyed by the meltdown of 2007-09,
which as much as anything was a crisis of
modern metrics-based risk management.
The idea that markets can be left to police
themselves turned out to be the world’s
most expensive mistake, requiring $15 tril-
lion in capital injections and other forms
of support. �It has cost a lot to learn how lit-
tle we really knew,� says a senior central
banker. Another lesson was that managing
risk is as much about judgment as about
numbers. Trying ever harder to capture
The gods strike back
�THE revolutionary idea that de�nesthe boundary between
modern

times and the past is the mastery of risk:
the notion that the future is more than a
whim of the gods and that men and wom-
en are not passive before nature.� So wrote
Peter Bernstein in his seminal history of
risk, �Against the Gods�, published in 1996.
And so it seemed, to all but a few Cassan-
dras, for much of the decade that followed.
Finance enjoyed a golden period, with low
interest rates, low volatility and high re-
turns. Risk seemed to have been reduced
to a permanently lower level.
This purported new paradigm hinged,
in large part, on three closely linked devel-
opments: the huge growth of derivatives;
the decomposition and distribution of
credit risk through securitisation; and the
formidable combination of mathematics
and computing power in risk management
that had its roots in academic work of the
mid-20th century. It blossomed in the
1990s at �rms such as Bankers Trust and
JPMorgan, which developed �value-at-
risk� (VAR), a way for banks to calculate
how much they could expect to lose when
things got really rough.
Suddenly it seemed possible for any �-
nancial risk to be measured to �ve decimal
places, and for expected returns to be ad-
justed accordingly. Banks hired hordes of
PhD-wielding �quants� to �ne-tune ever
more complex risk models. The belief took
hold that, even as pro�ts were being boost-

An audio interview with the author is at
Economist.com/audiovideo
A list of sources is at
Economist.com/specialreports
Number-crunchers crunched
The uses and abuses of mathematical
models. Page 3
Cinderella’s moment
Risk managers to the fore. Page 6
A matter of principle
Why some banks did much better than
others. Page 7
When the river runs dry
The perils of a sudden evaporation of
liquidity.Page 8
Fingers in the dike
What regulators should do now. Page 10
Blocking out the sirens’ song
Moneymen need saving from themselves.
Page 13
Also in this section
Acknowledgments
In addition to those mentioned in the text, the author
would like to thank the following for their help in
preparing this report: Madelyn Antoncic, Scott Baret,

Richard Bookstaber, Kevin Buehler, Jan Brockmeijer,
Stephen Cecchetti, Mark Chauvin, John Cochrane, José
Corral, Wilson Ervin, Dan Fields, Chris Finger, Bennett
Golub, John Hogan, Henry Hu, Simon Johnson, Robert
Kaplan, Steven Kaplan, Anil Kashyap, James Lam, Brian
Leach, Robert Le Blanc, Mark Levonian, Tim Long, Blythe
Masters, Michael Mendelson, Robert Merton, Jorge Mina,
Mary Frances Monroe, Lubos Pastor, Henry Ristuccia,
Brian Robertson, Daniel Sigrist, Pietro Veronesi, Jim
Wiener, Paul Wright and Luigi Zingales.
1
2 A special report on �nancial risk The Economist February
13th 2010
2
1
risk in mathematical formulae can be
counterproductive if such a degree of ac-
curacy is intrinsically unattainable.
For now, the hubris of spurious preci-
sion has given way to humility. It turns out
that in �nancial markets �black swans�, or
extreme events, occur much more often
than the usual probability models suggest.
Worse, �nance is becoming more fragile:
these days blow-ups are twice as frequent
as they were before the �rst world war, ac-
cording to Barry Eichengreen of the Uni-
versity of California at Berkeley and Mi-

chael Bordo of Rutgers University. Benoit
Mandelbrot, the father of fractal theory
and a pioneer in the study of market
swings, argues that �nance is prone to a
�wild� randomness not usually seen in na-
ture. In markets, �rare big changes can be
more signi�cant than the sum of many
small changes,� he says. If �nancial mar-
kets followed the normal bell-shaped dis-
tribution curve, in which meltdowns are
very rare, the stockmarket crash of 1987, the
interest-rate turmoil of 1992 and the 2008
crash would each be expected only once in
the lifetime of the universe.
This is changing the way many �nan-
cial �rms think about risk, says Greg Case,
chief executive of Aon, an insurance bro-
ker. Before the crisis they were looking at
things like pandemics, cyber-security and
terrorism as possible causes of black
swans. Now they are turning to risks from
within the system, and how they can be-
come ampli�ed in combination.
Cheap as chips, and just as bad for you
It would, though, be simplistic to blame
the crisis solely, or even mainly, on sloppy
risk managers or wild-eyed quants. Cheap
money led to the wholesale underpricing
of risk; America ran negative real interest
rates in 2002-05, even though consumer-
price in�ation was quiescent. Plenty of
economists disagree with the recent asser-
tion by Ben Bernanke, chairman of the
Federal Reserve, that the crisis had more to

do with lax regulation of mortgage pro-
ducts than loose monetary policy.
Equally damaging were policies to pro-
mote home ownership in America using
Fannie Mae and Freddie Mac, the coun-
try’s two mortgage giants. They led the duo
to binge on securities backed by shoddily
underwritten loans.
In the absence of strict limits, higher le-
verage followed naturally from low inter-
est rates. The debt of America’s �nancial
�rms ballooned relative to the overall
economy (see chart 1). At the peak of the
madness, the median large bank had bor-
rowings of 37 times its equity, meaning it
could be wiped out by a loss of just 2-3% of
its assets. Borrowed money allowed inves-
tors to fake �alpha�, or above-market re-
turns, says Benn Steil of the Council on
Foreign Relations.
The agony was compounded by the
proliferation of short-term debt to support
illiquid long-term assets, much of it issued
beneath the regulatory radar in highly le-
veraged �shadow� banks, such as struc-
tured investment vehicles. When markets
froze, sponsoring entities, usually banks,
felt morally obliged to absorb their losses.
�Reputation risk was shown to have a very
real �nancial price,� says Doug Roeder of
the O�ce of the Comptroller of the Cur-
rency, an American regulator.

Everywhere you looked, moreover, in-
centives were misaligned. Firms deemed
�too big to fail� nestled under implicit guar-
antees. Sensitivity to risk was dulled by the
�Greenspan put�, a belief that America’s
Federal Reserve would ride to the rescue
with lower rates and liquidity support if
needed. Scrutiny of borrowers was dele-
gated to rating agencies, who were paid by
the debt-issuers. Some products were so
complex, and the chains from borrower to
end-investor so long, that thorough due di-
ligence was impossible. A proper under-
standing of a typical collateralised debt ob-
ligation (CDO), a structured bundle of debt
securities, would have required reading
30,000 pages of documentation.
Fees for securitisers were paid largely
upfront, increasing the temptation to origi-
nate, �og and forget. The problems with
bankers’ pay went much wider, meaning
that it was much better to be an employee
than a shareholder (or, eventually, a tax-
payer picking up the bail-out tab). The role
of top executives’ pay has been over-
blown. Top brass at Lehman Brothers and
American International Group (AIG) suf-
fered massive losses when share prices
tumbled. A recent study found that banks
where chief executives had more of their
wealth tied up in the �rm performed
worse, not better, than those with appar-
ently less strong incentives. One explana-

tion is that they took risks they thought
were in shareholders’ best interests, but
were proved wrong. Motives lower down
the chain were more suspect. It was too
easy for traders to cash in on short-term
gains and skirt responsibility for any time-
bombs they had set ticking.
Asymmetries wreaked havoc in the
vast over-the-counter derivatives market,
too, where even large dealing �rms lacked
the information to determine the conse-
quences of others failing. Losses on con-
tracts linked to Lehman turned out to be
modest, but nobody knew that when it
collapsed in September 2008, causing pan-
ic. Likewise, it was hard to gauge the expo-
sures to �tail� risks built up by sellers of
swaps on CDOs such as AIG and bond in-
surers. These were essentially put options,
with limited upside and a low but real
probability of catastrophic losses.
Another factor in the build-up of exces-
sive risk was what Andy Haldane, head of
�nancial stability at the Bank of England,
has described as �disaster myopia�. Like
drivers who slow down after seeing a
crash but soon speed up again, investors
exercise greater caution after a disaster, but
these days it takes less than a decade to
make them reckless again. Not having seen
a debt-market crash since 1998, investors
piled into ever riskier securities in 2003-07
to maintain yield at a time of low interest
rates. Risk-management models rein-

forced this myopia by relying too heavily
on recent data samples with a narrow dis-
tribution of outcomes, especially in sub-
prime mortgages.
A further hazard was summed up by
the assertion in 2007 by Chuck Prince, then
Citigroup’s boss, that �as long as the music
is playing, you’ve got to get up and dance.�
Performance is usually judged relative to
rivals or to an industry benchmark, en-
couraging banks to mimic each other’s
risk-taking, even if in the long run it bene-
�ts no one. In mortgages, bad lenders
drove out good ones, keeping up with ag-
gressive competitors for fear of losing mar-
ket share. A few held back, but it was not
easy: when JPMorgan sacri�ced �ve per-
centage points of return on equity in the
short run, it was lambasted by share-
holders who wanted it to �catch up� with
zippier-looking rivals.
An overarching worry is that the com-
1Borrowed time
Source: Federal Reserve
US financial-industry debt as % of GDP
0
20
40

60
80
100
120
1978 1988 1998 2008
�nancial risk 3
2
1
plexity of today’s global �nancial network
makes occasional catastrophic failure in-
evitable. For example, the market for credit
derivatives galloped far ahead of its sup-
porting infrastructure. Only now are seri-
ous moves being made to push these con-
tracts through central clearing-houses
which ensure that trades are properly col-
lateralised and guarantee their completion
if one party defaults.
Network overload
The push to allocate capital ever more e�-
ciently over the past 20 years created what
Till Guldimann, the father of VAR and
vice-chairman of SunGard, a technology

�rm, calls �capitalism on steroids�. Banks
got to depend on the modelling of prices in
esoteric markets to gauge risks and became
adept at gaming the rules. As a result, capi-
tal was not being spread around as e�-
ciently as everyone believed.
Big banks had also grown increasingly
interdependent through the boom in de-
rivatives, computer-driven equities trad-
ing and so on. Another bond was cross-
ownership: at the start of the crisis, �nan-
cial �rms held big dollops of each other’s
common and hybrid equity. Such tight
coupling of components increases the
danger of �non-linear� outcomes, where a
small change has a big impact. �Financial
markets are not only vulnerable to black
swans but have become the perfect breed-
ing ground for them,� says Mr Guldimann.
In such a network a �rm’s troubles can
have an exaggerated e�ect on the per-
ceived riskiness of its trading partners.
When Lehman’s credit-default spreads
rose to distressed levels, AIG’s jumped by
twice what would have been expected on
its own, according to the International
Monetary Fund.
Mr Haldane has suggested that these
knife-edge dynamics were caused not only
by complexity but also�paradoxically�by
homogeneity. Banks, insurers, hedge funds
and others bought smorgasbords of debt
securities to try to reduce risk through di-

versi�cation, but the ingredients were sim-
ilar: leveraged loans, American mortgages
and the like. From the individual �rm’s
perspective this looked sensible. But for
the system as a whole it put everyone’s
eggs in the same few baskets, as re�ected in
their returns (see chart 2).
E�orts are now under way to deal with
these risks. The Financial Stability Board,
an international group of regulators, is try-
ing to co-ordinate global reforms in areas
such as capital, liquidity and mechanisms
for rescuing or dismantling troubled
banks. Its biggest challenge will be to make
the system more resilient to the failure of
giants. There are deep divisions over how
to set about this, with some favouring
tougher capital requirements, others
break-ups, still others�including Ameri-
ca�a combination of remedies.
In January President Barack Obama
shocked big banks by proposing a tax on
their liabilities and a plan to cap their size,
ban �proprietary� trading and limit their
involvement in hedge funds and private
equity. The proposals still need congressio-
nal approval. They were seen as energising
the debate about how to tackle dangerous-
ly large �rms, though the reaction in Eu-
rope was mixed.
Regulators are also inching towards a
more �systemic� approach to risk. The old

supervisory framework assumed that if
the 100 largest banks were individually
safe, then the system was too. But the crisis
showed that even well-managed �rms,
acting prudently in a downturn, can un-
dermine the strength of all.
The banks themselves will have to �nd
a middle ground in risk management,
somewhere between gut feeling and num-
ber fetishism. Much of the progress made
in quantitative �nance was real enough,
but a �rm that does not understand the
�aws in its models is destined for trouble.
This special report will argue that rules
will have to be both tightened and better
enforced to avoid future crises�but that all
the reforms in the world will never guaran-
tee total safety. 7
2In lockstep
Source: “Banking on the State” by Andrew Haldane and
Piergiorgio Alessandri; Bank for International Settlements
Weighted average cumulative total returns, %
2000 01 02 03 04 05 06 07 08 09
50
0
50
100

150
200
+
–
Large complex
financial
institutions
Banks
Insurers
Hedge funds
IT PUT noses out of joint, but it changedmarkets for good. In
the mid-1970s a few
progressive occupants of Chicago’s op-
tions pits started trading with the aid of
sheets of theoretical prices derived from a
model and sold by an economist called
Fisher Black. Rivals, used to relying on their
wits, were unimpressed. One model-
based trader complained of having his pa-
pers snatched away and being told to
�trade like a man�. But the strings of num-
bers caught on, and soon derivatives ex-
changes hailed the Black-Scholes model,
which used share and bond prices to calcu-
late the value of derivatives, for helping to
legitimise a market that had been derided
as a gambling den.

Thanks to Black-Scholes, options pric-
ing no longer had to rely on educated
guesses. Derivatives trading got a huge
boost and quants poured into the industry.
By 2005 they accounted for 5% of all �-
nance jobs, against 1.2% in 1980, says Thom-
as Philippon of New York University�and
probably a much higher proportion of pay.
By 2007 �nance was attracting a quarter of
all graduates from the California Institute
of Technology.
These eggheads are now in the dock,
along with their probabilistic models. In
America a congressional panel is investi-
gating the models’ role in the crash. Wired,
a publication that can hardly be accused of
technophobia, has described default-prob-
ability models as �the formula that killed
Wall Street�. Long-standing critics of risk-
modelling, such as Nassim Nicholas Taleb,
author of �The Black Swan�, and Paul Wil-
mott, a mathematician turned �nancial
educator, are now hailed as seers. Models
�increased risk exposure instead of limit-
ing it�, says Mr Taleb. �They can be worse
Number-crunchers crunched
The uses and abuses of mathematical models
13th 2010

2
1
than nothing, the equivalent of a danger-
ous operation on a patient who would
stand a better chance if left untreated.�
Not all models were useless. Those for
interest rates and foreign exchange per-
formed roughly as they were meant to.
However, in debt markets they failed ab-
jectly to take account of low-probability
but high-impact events such as the gut-
wrenching fall in house prices.
The models went particularly awry
when clusters of mortgage-backed securi-
ties were further packaged into collateral-
ised debt obligations (CDOs). In traditional
products such as corporate debt, rating
agencies employ basic credit analysis and
judgment. CDOs were so complex that
they had to be assessed using specially de-
signed models, which had various faults.
Each CDO is a unique mix of assets, but the
assumptions about future defaults and
mortgage rates were not closely tailored to
that mix, nor did they factor in the tenden-
cy of assets to move together in a crisis.
The problem was exacerbated by the
credit raters’ incentive to accommodate
the issuers who paid them. Most �nancial
�rms happily relied on the models, even

though the expected return on AAA-rated
tranches was suspiciously high for such
apparently safe securities. At some banks,
risk managers who questioned the rating
agencies’ models were given short shrift.
Moody’s and Standard & Poor’s were as-
sumed to know best. For people paid ac-
cording to that year’s revenue, this was un-
derstandable. �A lifetime of wealth was
only one model away,� sneers an Ameri-
can regulator.
Moreover, heavy use of models may
have changed the markets they were sup-
posed to map, thus undermining the valid-
ity of their own predictions, says Donald
MacKenzie, an economic sociologist at the
University of Edinburgh. This feedback
process is known as counter-performativ-
ity and had been noted before, for instance
with Black-Scholes. With CDOs the mod-
els’ popularity boosted demand, which
lowered the quality of the asset-backed se-
curities that formed the pools’ raw materi-
al and widened the gap between expected
and actual defaults (see chart 3).
A related problem was the similarity of
risk models. Banks thought they were div-
ersi�ed, only to �nd that many others held
comparable positions, based on similar
models that had been built to comply with
the Basel 2 standards, and everyone was
trying to unwind the same positions at the
same time. The breakdown of the models,
which had been the only basis for pricing

the more exotic types of security, turned
risk into full-blown uncertainty (and thus
extreme volatility).
For some, the crisis has shattered faith
in the precision of models and their inputs.
They failed Keynes’s test that it is better to
be roughly right than exactly wrong. One
number coming under renewed scrutiny is
�value-at-risk� (VAR), used by banks to
measure the risk of loss in a portfolio of �-
nancial assets, and by regulators to calcu-
late banks’ capital bu�ers. Invented by egg-
heads at JPMorgan in the late 1980s, VAR
has grown steadily in popularity. It is the
subject of more than 200 books. What
makes it so appealing is that its complex
formulae distil the range of potential daily
pro�ts or losses into a single dollar �gure.
Only so far with VAR
Frustratingly, banks introduce their own
quirks into VAR calculations, making com-
parison di�cult. For example, Morgan
Stanley’s VAR for the �rst quarter of 2009
by its own reckoning was $115m, but using
Goldman Sachs’s method it would have
been $158m. The bigger problem, though, is
that VAR works only for liquid securities
over short periods in �normal� markets,
and it does not cover catastrophic out-
comes. If you have $30m of two-week 1%
VAR, for instance, that means there is a 99%
chance that you will not lose more than
that amount over the next fortnight. But

there may be a huge and unacknowledged
threat lurking in that 1% tail.
So chief executives would be foolish to
rely solely, or even primarily, on VAR to
manage risk. Yet many managers and
boards continue to pay close attention to it
without fully understanding the caveats�
the equivalent of someone who cannot
swim feeling con�dent of crossing a river
having been told that it is, on average, four
feet deep, says Jaidev Iyer of the Global As-
sociation of Risk Professionals.
Regulators are encouraging banks to
look beyond VAR. One way is to use Co-
VAR (Conditional VAR), a measure that
aims to capture spillover e�ects in trou-
bled markets, such as losses due to the dis-
tress of others. This greatly increases some
banks’ value at risk. Banks are developing
their own enhancements. Morgan Stanley,
for instance, uses �stress� VAR, which fac-
tors in very tight liquidity constraints.
Like its peers, Morgan Stanley is also re-
viewing its stress testing, which is used to
consider extreme situations. The worst sce-
nario envisaged by the �rm turned out to
be less than half as bad as what actually
happened in the markets. JPMorgan
Chase’s debt-market stress tests foresaw a
40% increase in corporate spreads, but
high-yield spreads in 2007-09 increased
many times over. Others fell similarly

short. Most banks’ tests were based on his-
torical crises, but this assumes that the fu-
ture will be similar to the past. �A repeat of
any speci�c market event, such as 1987 or
1998, is unlikely to be the way that a future
crisis will unfold,� says Ken deRegt, Mor-
gan Stanley’s chief risk o�cer.
Faced with either random (and there-
fore not very believable) scenarios or sim-
plistic models that neglect fat-tail risks,
many �nd themselves in a �no-man’s-
land� between the two, says Andrew Free-
man of Deloitte (and formerly a journalist
at The Economist). Nevertheless, he views
scenario planning as a useful tool. A �rm
that had thought about, say, the mutation
of default risk into liquidity risk would
have had a head start over its competitors
in 2008, even if it had not predicted pre-
cisely how this would happen.
To some, stress testing will always seem
maddeningly fuzzy. �It has so far been seen
as the acupuncture-and-herbal-remedies
corner of risk management, though per-
ceptions are changing,� says Riccardo Reb-
onato of Royal Bank of Scotland, who is
writing a book on the subject. It is not
meant to be a predictive tool but a means
of considering possible outcomes to allow
�rms to react more nimbly to unexpected
developments, he argues. Hedge funds are
better at this than banks. Some had
thought about the possibility of a large
broker-dealer going bust. At least one,

AQR, had asked its lawyers to grill the
fund’s prime brokers about the fate of its
assets in the event of their demise.
3Never mind the quality
Source: Donald MacKenzie, University of Edinburgh
CDOs of subprime-mortgage-backed securities
Issued in 2005-07, %
Estimated Actual
3-year default default
rate rate
AAA 0.001 0.10
AA+ 0.01 1.68
AA 0.04 8.16
AA- 0.05 12.03
A+ 0.06 20.96
A 0.09 29.21
A- 0.12 36.65
BBB+ 0.34 48.73
BBB 0.49 56.10
BBB- 0.88 66.67

�nancial risk 5
2 Some of the blame lies with bank regu-
lators, who were just as blind to the dan-
gers ahead as the �rms they oversaw.
Sometimes even more so: after the rescue
of Bear Stearns in March 2008 but before
Lehman’s collapse, Morgan Stanley was re-
portedly told by supervisors at the Federal
Reserve that its doomsday scenario was
too bearish.
The regulators have since become
tougher. In America, for instance, banks
have been told to run stress tests with sce-
narios that include a huge leap in interest
rates. A supervisors’ report last October
�ngered some banks for �window-dress-
ing� their tests. O�cials are now asking for
�reverse� stress testing, in which a �rm
imagines it has failed and works back-
wards to determine which vulnerabilities
caused the hypothetical collapse. Britain
has made this mandatory. Bankers are di-
vided over its usefulness.
Slicing the Emmental
These changes point towards greater use of
judgment and less reliance on numbers in
future. But it would be unfair to tar all mod-
els with the same brush. The CDO �asco
was an egregious and relatively rare case
of an instrument getting way ahead of the
ability to map it mathematically. Models

were �an accessory to the crime, not the
perpetrator�, says Michael Mauboussin of
Legg Mason, a money manager.
As for VAR, it may be hopeless at signal-
ling rare severe losses, but the process by
which it is produced adds enormously to
the understanding of everyday risk, which
can be just as deadly as tail risk, says Aaron
Brown, a risk manager at AQR. Craig Bro-
derick, chief risk o�cer at Goldman Sachs,
sees it as one of several measures which,
although of limited use individually, to-
gether can provide a helpful picture. Like a
slice of Swiss cheese, each number has
holes, but put several of them together and
you get something solid.
Modelling is not going away; indeed,
number-crunchers who are devising new
ways to protect investors from outlying fat-
tail risks are gaining in�uence. Pimco, for
instance, o�ers fat-tail hedging pro-
grammes for mutual-fund clients, using
cocktails of options and other instru-
ments. These are built on speci�c risk fac-
tors rather than on the broader and in-
creasingly �uid division of assets between
equities, currencies, commodities and so
on. The relationships between asset class-
es �have become less stable�, says Mo-
hamed El-Erian, Pimco’s chief executive.
�Asset-class diversi�cation remains desir-
able but is not su�cient.�
Not surprisingly, more investors are

now willing to give up some upside for the
promise of protection against catastrophic
losses. Pimco’s clients are paying up to 1%
of the value of managed assets for the
hedging�even though, as the recent crisis
showed, there is a risk that insurers will
not be able to pay out. Lisa Goldberg of
MSCI Barra reports keen interest in the an-
alytics �rm’s extreme-risk model from
hedge funds, investment banks and pen-
sion plans.
In some areas the need may be for more
computing power, not less. Financial �rms
already spend more than any other indus-
try on information technology (IT): some
$500 billion in 2009, according to Gartner,
a consultancy. Yet the quality of informa-
tion �ltering through to senior managers is
often inadequate.
A report by bank supervisors last Octo-
ber pointed to poor risk �aggregation�:
many large banks simply do not have the
systems to present an up-to-date picture of
their �rm-wide links to borrowers and
trading partners. Two-thirds of the banks
surveyed said they were only �partially�
able (in other words, unable) to aggregate
their credit risks. The Federal Reserve, lead-
ing stress tests on American banks last
spring, was shocked to �nd that some of
them needed days to calculate their expo-
sure to derivatives counterparties.

To be fair, totting up counterparty risk is
not easy. For each trading partner the cal-
culations can involve many di�erent types
of contract and hundreds of legal entities.
But banks will have to learn fast: under
new international proposals, they will for
the �rst time face capital charges on the
creditworthiness of swap counterparties.
The banks with the most dysfunctional
systems are generally those, such as Citi-
group, that have been through multiple
marriages and ended up with dozens of
�legacy� systems that cannot easily com-
municate with each other. That may ex-
plain why some Citi units continued to
pile into subprime mortgages even as oth-
ers pulled back.
In the depths of the crisis some banks
were unaware that di�erent business units
were marking the same assets at di�erent
prices. The industry is working to sort this
out. Banks are coming under pressure to
appoint chief data o�cers who can police
the integrity of the numbers, separate from
chief information o�cers who concen-
trate on system design and output.
Some worry that the good work will be
cast aside. As markets recover, the biggest
temptation will be to abandon or scale
back IT projects, allowing product devel-
opment to get ahead of the supporting
technology infrastructure, just as it did in

the last boom.
The way forward is not to reject high-
tech �nance but to be honest about its limi-
tations, says Emanuel Derman, a professor
at New York’s Columbia University and a
former quant at Goldman Sachs. Models
should be seen as metaphors that can en-
lighten but do not describe the world per-
fectly. Messrs Derman and Wilmott have
drawn up a modeller’s Hippocratic oath
which pledges, among other things: �I will
remember that I didn’t make the world,
and it doesn’t satisfy my equations,� and �I
will never sacri�ce reality for elegance
without explaining why I have done so.�
Often the problem is not complex �nance
but the people who practise it, says Mr Wil-
mott. Because of their love of puzzles,
quants lean towards technically brilliant
rather than sensible solutions and tend to
over-engineer: �You may need a plumber
but you get a professor of �uid dynamics.�
One way to deal with that problem is to
self-insure. JPMorgan Chase holds $3 bil-
lion of �model-uncertainty reserves� to
cover mishaps caused by quants who have
been too clever by half. If you can make
provisions for bad loans, why not bad
maths too? 7
13th 2010

1
IN A speech delivered to a banking-indus-try conference in
Geneva in December
2006, Madelyn Antoncic issued a warning
and then o�ered some reassurance. With
volatility low, corporate credit spreads
growing ever tighter and markets all but ig-
noring bad news, there was, she said, �a
seemingly overwhelming sense of com-
placency�. Nevertheless, she insisted that
the �rm she served as chief risk o�cer,
Lehman Brothers, was well placed to ride
out any turbulence, thanks to a keen
awareness of emerging threats and a rock-
solid analytical framework.
Behind the scenes, all was not well. Ms
Antoncic, a respected risk manager with
an economics PhD, had expressed unease
at the �rm’s heavy exposure to commer-
cial property and was being sidelined, bit
by bit, by the �rm’s autocratic boss, Dick
Fuld. Less than two months after her
speech she was pushed aside.
Lehman’s story ended particularly bad-
ly, but this sort of lapse in risk governance
was alarmingly common during the
boom. So much for the notion, generally
accepted back then, that the quality of
banks’ risk regimes had, like car compo-
nents, converged around a high standard.
�The variance turned out to be shocking,�
says Jamie Dimon, chief executive of

JPMorgan Chase.
The banks that fared better, including
his own, relied largely on giving their risk-
managing roundheads equal status with
the risk-taking cavaliers. That was not easy.
In happy times, when risk seems low, pow-
er shifts from risk managers to traders.
Sales-driven cultures are the natural order
of things on Wall Street and in the City. Dis-
couraging transactions was frowned upon,
especially at �rms trying to push their way
up capital-markets league tables. Risk
managers who said no put themselves on
a collision course with the business head
and often the chief executive too.
At some large banks that subsequently
su�ered big losses, such as HBOS and Roy-
al Bank of Scotland (RBS), credit commit-
tees, which vetted requests for big loans,
could be formed on an ad hoc basis from a
pool of eligible members. If the commit-
tee’s chairman, typically a business-line
head, encountered resistance from a risk
manager or other sceptic, he could adjourn
the meeting, then reconstitute the commit-
tee a week or two later with a more pliable
membership that would approve the loan.
Another common trick was for a busi-
ness line to keep quiet about a proposal on
which it had been working for weeks until
a couple of hours before the meeting to ap-
prove it, so the risk team had no time to

lodge convincing objections. Exasperated
roundheads would occasionally resort to
pleading with regulators for help. In the
years before the crash the Basel Commit-
tee of bank supervisors reportedly re-
ceived several requests from risk managers
to scrutinise excessive risk-taking at their
institutions that they felt powerless to stop.
Many banks’ failings exposed the tri-
umph of form over substance. In recent
years it had become popular to appoint a
chief risk o�cer to signal that the issue was
receiving attention. But according to Leo
Grepin of McKinsey, �it was sometimes a
case of management telling him, ‘you tick
the boxes on risk, and we’ll worry about
generating revenue’.�
Since 2007 banks have been scram-
bling to convince markets and regulators
that they will continue to take risk serious-
ly once memories of the crisis fade. Some
are involving risk o�cers in talks about
new products and strategic moves. At
HSBC, for instance, they have had a bigger
role in vetting acquisitions since the bank’s
American retail-banking subsidiary,
bought in 2003, su�ered heavy subprime-
mortgage losses. �Everyone should now
see that the risk team needs to be just as in-
volved on the returns side as on the risk
side,� says Maureen Miskovic, chief risk of-
�cer at State Street, an American bank.

Glamming up
Ms Miskovic is one of an emerging breed
of more powerful risk o�cers. They are
seen as being on a par with the chief �nan-
cial o�cer, get a say in decisions on pay
and have the ear of the board, whose
agreement is increasingly needed to re-
move them. Some report directly to a
board committee as well as�or occasional-
ly instead of�to the chief executive.
For many, the biggest task is to disman-
tle cumbersome �silos�, says Ken Chalk of
Cinderella’s moment
Risk managers to the fore
�nancial risk 7
2
1
America’s Risk Management Association.
Risks were often stu�ed into convenient
but misleading pigeonholes. Banks were
slow to re�ne their approach, even as
growing market complexity led some of
the risks to become interchangeable.
Take the growth of traded credit pro-
ducts, such as asset-backed securities and

CDOs made up of them. Credit-risk de-
partments thought of them as market risk,
because they sat in the trading book. Mar-
ket-risk teams saw them as credit instru-
ments, since the underlying assets were
loans. This buck-passing proved particu-
larly costly at UBS, which lost SFr36 billion
($34 billion) on CDOs. Many banks are
now combining their market- and credit-
risk groups, as HSBC did last year.
For all the new-found authority of risk
managers, it can still be hard to attract tal-
ent to their ranks. The job is said to have
the risk pro�le of a short option position
with unlimited downside and limited up-
side�something every good risk manager
should avoid. Moreover, it lacks glamour.
Persuading a trader to move to risk can be
�like asking a trapeze artist to retrain as an
accountant�, says Barrie Wilkinson of Oli-
ver Wyman, a consultancy.
A question of culture
Besides, there is more to establishing a sol-
id risk culture than empowering risk o�-
cers. Culture is a slippery concept, but it
matters. �Whatever causes the next crisis,
it will be di�erent, so you need something
that can deal with the unexpected. That’s
culture,� says Colm Kelleher of Morgan
Stanley. One necessary ingredient is a tra-
dition of asking and repeating questions
until a clear answer emerges, suggests
Clayton Rose, a banker who now teaches
at Harvard Business School.

The tone is set at the top, for better or
worse. At the best-run banks senior �gures
spend as much time fretting over risks as
they do salivating at opportunities (see
box). By contrast, Lehman’s Mr Fuld talked
of �protecting mother� but was drawn to
the glister of leveraged deals. Stan O’Neal,
who presided over giant losses at Merrill
Lynch, was more empire-builder than risk
manager. But imperial bosses and sound
risk cultures sometimes go together, as at
JPMorgan and Banco Santander.
A soft-touch boss can be more danger-
ous than a domineering one. Under Chuck
Prince, who famously learned only in Sep-
tember 2007 that Citigroup was sitting on
$43 billion of toxic assets, the lunatics were
able to take over the asylum. Astonishing-
ly, the head of risk reported not to Mr
Prince or the board, but to a newly hired ex-
ecutive with a background in corporate-go-
vernance law, not cutting-edge �nance.
Another lesson is that boards matter
too. Directors’ lack of engagement or ex-
pertise played a big part in some of the
worst slip-ups, including Citi’s. The �so-
ciology� of big banks’ boards also had
something to do with it, says Ingo Walter
of New York’s Stern School of Business: as
the members bonded, dissidents felt pres-
sure to toe the line.

Too few boards de�ned the parameters
of risk oversight. In a survey last year De-
loitte found that only seven of 30 large
banks had done so in any detail. Everyone
agrees that boards have a critical role to
play in determining risk appetite, but a re-
cent report by a group of global regulators
found that many were reluctant to do this.
Boards could also make a better job of
policing how (or even whether) banks ad-
just for risk in allocating capital internally.
Before the crisis some boards barely
thought about this, naively assuming that
procedures for it were well honed. A for-
mer Lehman board member professes
himself �astonished�, in retrospect, at how
JPMORGAN CHASE managed to avoidbig losses largely thanks
to the tone set
by its boss, Jamie Dimon. A voracious
reader of internal reports, he understands
�nancial arcana and subjects sta� to de-
tailed questioning. PowerPoint presenta-
tions are discouraged, informal discus-
sions of what is wrong, or could go
wrong, encouraged. These �soft� princi-
ples are supplemented by a hard-headed
approach to the allocation of capital.
Though the bank su�ered painful losses
in leveraged loans, it was not tripped up
by CDOs or structured investment vehi-
cles (SIVs), even though it had been in-
strumental in developing both products.

Nor was it heavily exposed to AIG, an in-
surance giant that got into trouble.
This was not because it saw disaster
coming, says Bill Winters, former co-head
of the �rm’s investment bank, but be-
cause it stuck by two basic principles:
don’t hold too much of anything, and
only keep what you are sure will generate
a decent risk-adjusted return. The bank
jettisoned an SIV and $60 billion of CDO-
related risks because it saw them as too
dicey, at a time when others were still
keen to snap them up. It also closed 60
credit lines for other SIVs and corporate
clients when it realised that these could
be simultaneously drawn down if the
bank’s credit rating were cut. And it took a
conservative view of risk-mitigation.
Hedging through bond insurers, whose �-
nances grew shaky as the crisis spread,
was calculated twice: once assuming the
hedge would hold, and again assuming it
was worthless.
Goldman Sachs’s risk management
stood out too�unlike the public-relations
skills it subsequently displayed. Steered
by its chief �nancial o�cer, David Viniar,
the �rm’s traders began reducing their ex-
posure to mortgage securities months be-
fore subprime defaults began to explode.
More willing than rivals to take risks,
Goldman is also quicker to hedge them.
In late 2006 it spent up to $150m�one-

eighth of that quarter’s operating pro�t�
hedging exposure to AIG.
The �rm promotes senior traders to
risk positions, making clear that such
moves are a potential stepping stone to
the top. Traders are encouraged to nurture
the risk manager in them: Gary Cohn, the
�rm’s president, rose to the top largely be-
cause of his skill at hedging �tail� risks.
Crucially, Goldman generally does not
�re its risk managers after a crisis, allow-
ing them to learn from the experience. Yet
despite everything, it still needed govern-
ment help to survive.
By contrast, UBS’s risk culture was aw-
ful. Its investment bank was free to bet
with subsidised funds, since transfers
from the private bank were deeply under-
priced. It confused itself by presenting
risk in a �net and forget� format. Trading
desks would estimate the maximum pos-
sible loss on risky assets, hedge it and
then record the net risk as minimal, inad-
vertently concealing huge tail risks in the
gross exposure. And it moved its best trad-
ers to a hedge fund, leaving the B-team to
manage the bank’s positions.
Publicly humbled by a frank report on
its failings, the bank has made a raft of
changes. Risk controllers have been hand-
ed more power. Oswald Grübel, the chief
executive, has said that if his newish risk
chief, Philip Lofts, rejects a transaction he

will never overrule him. If the two dis-
agree, Mr Lofts must inform the board,
which no longer delegates risk issues to a
trio of long-time UBS employees. A new,
independent risk committee is bristling
with risk experts. Whether all this
amounts to a �new paradigm�, as Mr
Lofts claims, remains to be seen.
Why some banks did much better than others
A matter of principle
13th 2010
2
1
some of the risks in the company’s proper-
ty investments were brushed aside when
assessing expected returns. The survivors
are still struggling to create the sort of
joined-up approach to risk adjustment
that is common at large hedge funds, ad-
mits one Wall Street executive.
Board games
Robert Pozen, head of MFS Investment
Management, an American asset manager,
thinks bank boards would be more e�ec-
tive with fewer but more committed mem-
bers. Cutting their size to 4-8, rather than

the 10-18 typical now, would foster more
personal responsibility. More �nancial-
services expertise would help too. After
the passage of the Sarbanes-Oxley act in
2002 banks hired more independent direc-
tors, many of whom lacked relevant expe-
rience. The former spymaster on Citi’s
board and the theatrical impresario on
Lehman’s may have been happy to ask
questions, but were they the right ones?
Under regulatory pressure, banks such
as Citi and Bank of America have hired
more directors with strong �nancial-ser-
vices backgrounds. Mr Pozen suggests as-
sembling a small cadre of �nancially �u-
ent �super-directors� who would meet
more often�say, two or three days a month
rather than an average of six days a year, as
now�and may serve on only one other
board to ensure they take the job seriously.
That sounds sensible, but the case for
another suggested reform�creating inde-
pendent risk committees at board level�is
less clear. At some banks risk issues are
handled perfectly well by the audit com-
mittee or the full board. Nor is there a clear
link between the frequency of risk-related
meetings and a bank’s performance. At
Spain’s Santander the relevant committee
met 102 times in 2008. Those of other
banks that emerged relatively unscathed,
such as JPMorgan and Credit Suisse, con-
vened much less often.

Moreover, some of the most important
risk-related decisions of the next few years
will come from another corner: the com-
pensation committee. It is not just invest-
ment bankers and top executives whose
pay structures need to be rethought. In the
past, risk managers’ pay was commonly
determined or heavily in�uenced by the
managers of the trading desks they over-
saw, or their bonus linked to the desks’ per-
formance, says Richard Apostolik, who
heads the Global Association of Risk Pro-
fessionals (GARP). Boards need to elimi-
nate such con�icts of interest.
Meanwhile risk teams are being beefed
up. Morgan Stanley, for instance, is increas-
ing its complement to 450, nearly double
the number it had in 2008. The GARP saw
a 70% increase in risk-manager certi�ca-
tions last year. Risk is the busiest area for �-
nancial recruiters, says Tim Holt of Hei-
drick & Struggles, a �rm of headhunters.
When boards are looking for a new chief
executive, they increasingly want some-
one who has been head of risk as well as
chief �nancial o�cer, which used to be the
standard requirement, reckons Mike
Woodrow of Risk Talent Associates, an-
other headhunting �rm.
The big question is whether this inter-
est in controlling risk will �zzle out as econ-
omies recover. Experience suggests that it

will. Bankers say this time is di�erent�but
they always do. 7
STAMPEDING crowds can generate pres-sures of up to 4,500
Newtons per square
metre, enough to bend steel barriers. Rush-
es for the exit in �nancial markets can be
just as damaging. Investors crowd into
trades to get the highest risk-adjusted re-
turn in the same way that everyone wants
tickets for the best concert. When someone
shouts ��re�, their �ight creates an �endog-
enous� risk of being trampled by falling
prices, margin calls and vanishing capi-
tal�a �negative externality� that adds to
overall risk, says Lasse Heje Pedersen of
New York University.
This played out dramatically in 2008.
Liquidity instantly drained from securities
�rms as clients abandoned anything with
a whi� of risk. In three days in March Bear
Stearns saw its pool of cash and liquid as-
sets shrink by nearly 90%. After the col-
lapse of Lehman Brothers, Morgan Stanley
had $43 billion of withdrawals in a single
day, mostly from hedge funds.
Bob McDowall of Tower Group, a con-
sultancy, explains that liquidity poses �the
most emotional of risks�. Its loss can prove
just as fatal as insolvency. Many of those
clobbered in the crisis�including Bear
Stearns, Northern Rock and AIG�were
struck down by a sudden lack of cash or

funding sources, not because they ran out
of capital.
Yet liquidity risk has been neglected.
Over the past decade international regula-
tors have paid more attention to capital.
Banks ran liquidity stress tests and drew
up contingency funding plans, but often
half-heartedly. With markets awash with
cash and hedge funds, private-equity �rms
and sovereign-wealth funds all keen to in-
vest in assets, there seemed little prospect
of a liquidity crisis. Academics such as Mr
Pedersen, Lubos Pastor at Chicago’s Booth
School of Business and others were doing
solid work on liquidity shocks, but practi-
tioners barely noticed.
What makes liquidity so important is
its binary quality: one moment it is there in
abundance, the next it is gone. This time its
evaporation was particularly abrupt be-
cause markets had become so joined up.
The panic to get out of levered mortgage in-
vestments spilled quickly into interbank
loan markets, commercial paper, prime
brokerage, securities lending (lending
shares to short-sellers) and so on.
As con�dence ebbed, mortgage-backed
securities could no longer be used so easily
as collateral in repurchase or �repo� agree-
ments, in which �nancial �rms borrow
short-term from investors with excess
cash, such as money-market funds. This

was a big problem because securities �rms
had become heavily reliant on this market,
tripling their repo borrowing in the �ve
years to 2008. Bear Stearns had $98 billion
on its books, compared with $72 billion of
long-term debt.
Even the most liquid markets were af-
fected. In August 2007 a wave of selling of
blue-chip shares, forced by the need to cov-
er losses on debt securities elsewhere,
caused sudden drops of up to 30% for
some computer-driven strategies popular
with hedge funds.
Liquidity comes in two closely connect-
ed forms: asset liquidity, or the ability to
sell holdings easily at a decent price; and
When the river runs dry
The perils of a sudden evaporation of liquidity
�nancial risk 9
2
1
funding liquidity, or the capacity to raise �-
nance and roll over old debts when need-
ed, without facing punitive �haircuts� on
collateral posted to back this borrowing.

The years of excess saw a vast increase
in the funding of long-term assets with
short-term (and thus cheaper) debt. Short-
term borrowing has a good side: the threat
of lenders refusing to roll over can be a
source of discipline. Once they expect
losses, though, a run becomes inevitable:
they rush for repayment to beat the crowd,
setting o� a panic that might hurt them
even more. �Financial crises are almost al-
ways and everywhere about short-term
debt,� says Douglas Diamond of the Booth
School of Business.
Banks are founded on this �maturity
mismatch� of long- and short-term debt,
but they have deposit insurance which re-
duces the likelihood of runs. However, this
time much of the mismatched borrowing
took place in the uninsured �shadow�
banking network of investment banks,
structured o�-balance-sheet vehicles and
the like. It was supported by seemingly in-
genious structures. Auction-rate securities,
for instance, allowed the funding of stodgy
municipal bonds to be rolled over month-
ly, with the interest rate reset each time.
The past two years are littered with sto-
ries of schools and hospitals that came a
cropper after dramatically shortening the
tenure of their funding, assuming that the
savings in interest costs, small as they
were, far outweighed the risk of market sei-
zure. Securities �rms became equally com-

placent as they watched asset values rise,
boosting the value of their holdings as col-
lateral for repos. Commercial banks in-
creased their reliance on wholesale fund-
ing and on �ckle �non-core� deposits, such
as those bought from brokers.
Regulation did nothing to discourage
this, treating banks that funded them-
selves with deposits and those borrowing
overnight in wholesale markets exactly
the same. Markets viewed the second cate-
gory as more e�cient. Northern Rock,
which funded its mortgages largely in capi-
tal markets, had a higher stockmarket rat-
ing than HSBC, which relied more on con-
ventional deposits. The prevailing view
was that risk was inherent in the asset, not
the manner in which it was �nanced.
At the same time �nancial �rms built
up a host of liquidity obligations, not all of
which they fully understood. Banks were
expected to support o�-balance-sheet enti-
ties if clients wanted out; Citigroup had to
take back $58 billion of short-term securi-
ties from structured vehicles it sponsored.
AIG did not allow for the risk that the in-
surer would have to post more collateral
against credit-default swaps if these fell in
value or its rating was cut.
Now that the horse has bolted, �nan-
cial �rms are rushing to close the door, for
instance by adding to liquidity bu�ers (see

chart 4). British banks’ holdings of sterling
liquid assets are at their highest for a de-
cade. Capital-markets �rms are courting
deposits and shunning �ighty wholesale
funding. Deposits, equity and long-term
debt now make up almost two-thirds of
Morgan Stanley’s balance-sheet liabilities,
compared with around 40% at the end of
2007. Spending on liquidity-management
systems is rising sharply, with specialists
�almost able to name their price�, says one
banker. �Collateral management� has be-
come a buzzword.
Message from Basel
Regulators, too, are trying to make up for
lost time. In a �rst attempt to put numbers
on a nebulous concept, in December the
Basel Committee of central banks and su-
pervisors from 27 countries proposed a
global liquidity standard for international-
ly active banks. Tougher requirements
would reverse a decades-long decline in
banks’ liquidity cushions.
The new regime, which could be adopt-
ed as early as 2012, has two components: a
�coverage� ratio, designed to ensure that
banks have a big enough pool of high-
quality, liquid assets to weather an �acute
stress scenario� lasting for one month (in-
cluding such inconveniences as a sharp
ratings downgrade and a wave of collater-
al calls); and a �net stable funding� ratio,
aimed at promoting longer-term �nancing

of assets and thus limiting maturity mis-
matches. This will require a certain level of
funding to be for a year or more.
It remains to be seen how closely na-
tional authorities follow the script. Some
seem intent on going even further. In Swit-
zerland, UBS and Credit Suisse face a tri-
pling of the amount of cash and equiva-
lents they need to hold, to 45% of deposits.
Britain will require all domestic entities to
have enough liquidity to stand alone, un-
supported by their parent or other parts of
the group. Also controversial is the compo-
sition of the proposed liquidity cushions.
Some countries want to restrict these to
government debt, deposits with central
banks and the like. The Basel proposals al-
low high-grade corporate bonds too.
Banks have counter-attacked, arguing
that �trapping� liquidity in subsidiaries
would reduce their room for manoeuvre in
a crisis and that the bu�er rules are too re-
strictive; some, unsurprisingly, have called
for bank debt to be eligible. Under the Brit-
ish rules, up to 8% of banks’ assets could be
tied up in cash and gilts (British govern-
ment bonds) that they are forced to hold,
reckons Simon Hills of the British Bankers
Association, which could have �a huge im-
pact on business models�. That, some ar-
75
4Filling the pool

Sources: Federal Reserve; Goldman Sachs
US banks’ cash assets, $trn
0
0.25
0.50
0.75
1.00
1.25
1973 80 85 90 95 2000 05 09
13th 2010
2
1
gue, is precisely the point of reform.
Much can be done to reduce market
stresses without waiting for these reforms.
In repo lending�a decades-old practice
critical to the smooth functioning of mar-
kets�the Federal Reserve may soon
toughen collateral requirements and force

borrowers to draw up contingency plans
in case of a sudden freeze. Banks that clear
repos will be expected to monitor the size
and quality of big borrowers’ positions
more closely. The banks could live with
that, but they worry about proposals to
force secured short-term creditors to take
an automatic loss if a bank fails.
Another concern is prime brokerage,
banks’ �nancing of trading by hedge
funds. When the market unravelled, hedge
funds were unable to retrieve collateral
that their brokers had �rehypothecated�,
or used to fund transactions of their own;
billions of such unsegregated money is
still trapped in Lehman’s estate, reducing
dozens of its former clients to the status of
unsecured general creditors. Brokers suf-
fered in turn as clients pulled whatever
funds they could from those they viewed
as vulnerable. Temporary bans on short-
selling made things even worse, playing
havoc with some hedge funds’ strategies
and leaving them scrambling for cash. Reg-
ulators are moving towards imposing lim-
its on rehypothecation.
Early reform could also come to the se-
curities-lending market, in which institu-
tional investors lend shares from their
portfolios to short-sellers for a fee. Some
lenders�including, notoriously, AIG�
found they were unable to repay cash col-
lateral posted by borrowers because they

had invested it in instruments that had
turned illiquid, such as asset-backed com-
mercial paper. Some have doubled the
share of their portfolios that they know
they can sell overnight, to as much as 50%.
Regulators might consider asking them
to go further. Bond markets, unlike stock-
markets, revolve around quotes from deal-
ers. This creates a structural impediment to
the free �ow of liquidity in strained times,
argues Ken Froot of Harvard Business
School, because when dealers pull in their
horns they are unable to function properly
as market-makers. He suggests opening up
access to trade data and competition to
quote prices. Some senior �gures at the Fed
like the idea, as do money managers,
though predictably dealers are resisting.
Twin realities
The other brutal lesson of the crisis con-
cerns the way liquidity can a�ect solvency.
In a world of mark-to-market accounting, a
small price movement on a large, illiquid
portfolio can quickly turn into crippling
paper losses that eat into capital. Highly
rated but hard-to-shift debt instruments
can �nish you o� before losses on the un-
derlying loans have even begun to hurt
your cash �ows. If markets expect �re
sales, potential buyers will hold o� for a
better price, exacerbating fair-value losses.
In future banks will be more alert to

these dangers. �We were looking at the
bonds we held, focusing on the credit fun-
damentals. We lost sight of the capital hit
from illiquidity and marking to market
that can seriously hurt you in the mean-
time,� says Koos Timmermans, chief risk
o�cer at ING, a large Dutch banking and
insurance group. �We now know that you
have to treat the accounting reality as eco-
nomic reality.�
Another lesson is the �opportunity val-
ue� of staying liquid in good times, says
Aaron Brown, a risk manager with AQR, a
hedge fund. In an e�cient market dollar
bills are not left lying around. But in the dis-
located markets of late 2008 there were
lots of bargains to be had for the small mi-
nority of investors with dry powder.
For some, though, bigger liquidity pro-
blems may yet lie ahead. Some $5.1 trillion
of bank debt rated by Moody’s is due to
mature by 2012. This will have to be re�-
nanced at higher rates. The rates could also
be pushed up by an erosion of sovereign
credit quality, given implicit state guaran-
tees of bank liabilities. And, at some point,
banks face a reduction of cut-price liquid-
ity support from central banks�o�ered in
return for often dodgy collateral�which
has buoyed their pro�t margins. Mortgage
borrowers on teaser rates are vulnerable to
payment shock. So too are their lenders. 7
THE Delta Works are a series of dams,sluices and dikes built in

the second
half of the 20th century to protect the low-
est-lying parts of the Netherlands from the
sea. They are considered one of the seven
wonders of the modern world. The task
facing global regulators is to construct the
�nancial equivalent of this protective net-
work, said Jean-Claude Trichet, president
of the European Central Bank, in an inter-
view last November.
This will require success in three con-
nected areas: reducing the threat to stabil-
ity posed by �rms deemed too big to fail
because their demise could destabilise
markets; ensuring that banks have bigger
cushions against losses; and improving
system-wide, or macroprudential, regula-
tion. The work is under way, but some bits
are hobbled by a surfeit of architects, oth-
ers by a lack of clear plans.
¹ Too big to fail. Dealing with �systemical-
ly important� giants is the thorniest pro-
blem. Having once been cornered into a
choice between costly rescues and gut-
wrenching failures, governments are de-
termined to avoid a repeat. When markets
swooned, they were obliged to stand be-
hind the big and the highly connected (as
well as their creditors), but found them-
selves ill-equipped. Tim Geithner, Ameri-
ca’s treasury secretary, said his administra-
tion had nothing but �duct tape and string�
to deal with American International
Group (AIG) when it tottered.

The problem has only worsened dur-
ing the crisis. After a quarter-century of
ever-increasing �nancial concentration,
the giants of �nance grew even more dom-
inant in 2008-09 thanks to a series of shot-
gun takeovers of sickly rivals (see chart 5,
next page).
Regulators can tackle the issue either by
addressing the �too big� part (shrinking or
erecting �rewalls within giants) or the �to
fail� bit (forcing them to hold more capital
and making it easier to wind down bust
�rms). Until recently the focus was on the
second of these approaches. But since Pres-
ident Obama’s unveiling of two initiatives
last month�a tax on the liabilities of big
banks and the �Volcker rule�, which pro-
posed limits on their size and activities�
momentum has been shifting towards
Fingers in the dike
What regulators should do now
some combination of the two.
The Volcker plan�named after Paul
Volcker, the former Federal Reserve chair-
man who proposed it�calls for deposit-
takers to be banned from proprietary trad-
ing in capital markets and from investing in

hedge funds and private equity. The Finan-
cial Stability Board (FSB), a Basel-based
body that is spearheading the internation-
al reform drive, gave it a cautious welcome,
stressing that such a move would need to
be combined with tougher capital stan-
dards and other measures to be e�ective.
The Volcker rule does not seek a full
separation of commercial banking and in-
vestment banking. Nor is America pushing
to shrink its behemoths dramatically; for
most, the plan would merely limit further
growth of non-deposit liabilities (there is
already a 10% cap on national market share
in deposits). O�cials remain queasy about
dictating size limits. Citigroup’s woes sug-
gest a �rm can become too big to manage,
but JPMorgan Chase and HSBC are striking
counter-examples.
For all the hue and cry about the
Volcker plan, America sees it as supple-
menting earlier proposals, not supplanting
them. The most important of these is an
improved �resolution� mechanism for fail-
ing giants. Standard bankruptcy arrange-
ments do not work well for �nancial �rms:
in the time it takes for a typical case to
grind through court, the company’s value
will have evaporated.
America’s resolution plan would allow
regulators to seize and wind down basket-
cases. The challenge will be to convince

markets that these measures will not turn
into life-support machines. Worse, there is
no international agreement on how to
handle the failure of border-straddling
�rms, nor is one close. That was a huge pro-
blem with Lehman Brothers, which had
nearly 3,000 legal entities in dozens of
countries. And the struggle to retrieve $5.5
billion that a bust Icelandic bank owes
creditors in Britain and the Netherlands
still continues.
Questions also linger over the treat-
ment of lenders. America’s plan wants it
both ways, giving regulators discretion to
override private creditors but also to subor-
dinate the taxpayer’s claims. This fuels
concerns about handouts to politically fa-
voured groups, as happened in the govern-
ment-orchestrated bankruptcy of General
Motors. Another worrying precedent was
the generous treatment of troubled banks’
derivatives counterparties in 2008. All
counterparty trading exposures, to the ex-
tent that they are uncollateralised, should
be at the bottom of the capital stack, not at
the top. Regrettably, the opposite hap-
pened. This prompted a wave of credit-de-
fault-swap buying because these contracts
were underwritten by the state. �Today,
too big to fail means too many counter-
party exposures to fail,� says Peter Fisher
of BlackRock, a money manager.
¹ Overhauling capital requirements. In
the hope of avoiding having to trigger their

resolution regimes in the �rst place, regula-
tors will force banks to strengthen their
capital bu�ers. A number of countries are
considering a punitive capital surcharge
for the largest �rms. A report from the Bank
of England last November suggested va-
rious ways of designing this. It could vary
by sector, allowing regulators to in�uence
the marginal cost of lending to some of the
more exuberant parts of the economy. Or it
could re�ect the lender’s contribution to
systemic risk, based on its size, complexity
and the extent of its connections to other �-
nancial �rms.
How such a penalty would �t with
broader capital reforms is unclear. In De-
cember the Basel Committee of supervi-
sors and central banks laid out proposed
revisions to its global bank-capital regime.
These could come into force as early as
2012-13. The new standards, dubbed Basel
3, are less reliant than the last set of reforms
on banks’ own risk models. Then the talk
was of capital �e�ciency�. Now it is all
about robustness. With markets already
demanding that banks hold more equity, a
reversal of a long trend of falling ratios is
under way (see chart 6, next page).
Before the crisis banks could get away
with common equity�the purest form of
capital�of as little as 2% of risk-weighted
assets. The new regulatory minimum will
not be clear until later this year, but mar-
kets now dictate that banks hold four to

�ve times that level. Hybrid instruments�
part debt, part equity�will be discouraged
since these proved bad at absorbing losses.
Regulators are encouraging banks to issue
a di�erent type of convertible capital:
�contingent� bonds that automatically
turn into common shares at times of stress.
In another acknowledgment that rely-
ing too heavily on internal models was a
mistake, the new rules will be supple-
mented by a �leverage ratio�. Not weighted
99 01 03 05 07
5Big banks get bigger
Top five global banks and hedge funds
Assets as % of industry total
0
5
10
15
20
25
30

1998 2000 02 04 06 08 09
Global banks
Hedge funds
�nancial risk 11
2
1
13th 2010
2
1
to risk, this measure looks appealingly sim-
ple these days. One aim is to curb gaming
of risk-based requirements: European
banks, which unlike American ones were
not subject to a leverage ratio, could take
their borrowing to dangerous heights be-
cause many of their assets were highly rat-
ed securities with low risk weightings.
One o�cial likens the new approach to
placing a net under a trapeze artist.
In an equally big philosophical shift,
the new measures will lean against �procy-

clicality�, or the tendency of rules to exag-
gerate both the good and the bad. Banks
will be required to accumulate extra capi-
tal in fat years that can be drawn upon in
lean ones. Until now the rules have en-
couraged higher leverage in good times
and much lower in bad times, adding to
distress at just the wrong moment. Securi-
ties regulators contributed to the problem,
frowning on boom-time reserve-building
as possible pro�t-smoothing in disguise.
The new proposals will encourage �dy-
namic� provisioning, which allows banks
to squirrel away reserves based on expect-
ed losses, not just those already incurred.
Addressing procyclicality will also re-
quire tackling issues that straddle capital
rules and accounting standards. Critics of
fair-value (or �mark-to-market�) account-
ing, which requires assets to be held at
market prices (or an approximation), com-
plain that having to mark down assets to
the value they would fetch in illiquid mar-
kets is likely to exacerbate downturns. The
solution is not to abandon fair value,
which investors like because it is less open
to manipulation than the alternatives. But
there is a case for decoupling capital and
accounting rules, says Christian Leuz of
the Booth School of Business. This would
give bank regulators more discretion to ac-
cept alternative valuation methods yet still
allow investors to see the actual or estimat-
ed market value.

There are lots of potential devils in the
details of the proposals. A leverage ratio is
pointless without strict monitoring of as-
sets parked o� balance-sheets. Contingent
capital, meanwhile, could have the oppo-
site e�ect of that intended if the bank’s
trading partners �ee as its ratios near the
trigger point. There are also worries over
increases in capital charges for securitisa-
tions, exposure to swap counterparties
and the like. These make sense in theory;
to treat mortgage-backed securities as al-
most risk-free was nonsense. But the new
rules swing too far the other way, threaten-
ing to choke o� the recovery of asset-
backed markets.
America’s large banks, having repaid
their debts to taxpayers, are sure to wage
war on higher capital standards. An impact
assessment stretching over several months
will give them ample opportunity to look
for holes�and to lobby. In Europe, where
banks were more highly leveraged and
thus face a more wrenching adjustment,
even some supervisors are queasy.
¹ Improving macroprudential regulation.
In the meantime regulators can make pro-
gress in other areas, such as overhauling
day-to-day supervision. In both America
and Europe they have stepped up compari-
sons of pay, lending standards and the like
across big �rms. They are also introducing
peer review. Within the agency that over-
sees Swiss banks, for instance, the lead su-
pervisors of Credit Suisse and UBS are

now expected to scrutinise each other’s
work. America’s Securities and Exchange
Commission, whose failures included neg-
ligible supervision of investment banks
and the Mado� scandal, has set up a new
risk division packed with heavyweight
thinkers such as Henry Hu, Gregg Berman
and Richard Bookstaber. Part of their job
will be to scan derivatives markets, hedge
funds and the like for any emerging threats
to stability.
This stems from a recognition that tradi-
tional oversight needs to go hand in hand
with the macroprudential sort that takes
account of the collective behaviour of �-
nancial �rms, contagion e�ects and so on.
�Finance is full of clever instruments that
work as long as the risk is idiosyncratic, but
can wreak havoc if it becomes systemic,�
says Frederic Mishkin of Columbia Uni-
versity. Moreover, the crisis showed how
risk can cross traditional regulatory lines.
Pension funds and insurers, previously
seen as shock-absorbers, were revealed as
potential sources of systemic risk.
However, there is no broad agreement
on how systemic regulation might work,
or who should do the regulating. Most
economists see the job falling naturally to
central banks, because of their closeness to
markets and because of the link between
capital standards and monetary policy
through the price of credit. But there are

political obstacles, particularly in America,
where a large and vocal contingent in Con-
gress accuses the Fed itself of being a threat
to stability, pointing to loose monetary
policy as a cause of the housing mania.
International co-ordination is equally
tricky. The FSB has singled out 30 of the
largest banks and insurers for cross-border
scrutiny by �colleges� of supervisors.
There is, though, a natural limit to co-oper-
ation. It remains to be seen how well na-
tional risk regulators work with suprana-
tional bodies such as the European
Union’s systemic-risk council and the FSB.
Private-sector groups want to have their
say too: the Market Monitoring Group, a
collection of grandees linked to a banking-
industry group, is already issuing warn-
ings about fresh bubbles emerging.
Another reason for scepticism is the dif-
�culty of identifying a systemic event.
AIG’s liquidity crunch was thought to
count as one at the time, hence the o�er of
an $85 billion emergency loan from the
Fed. But what exactly was the danger? That
markets would be brought to their knees
by the failure of its derivatives counterpar-
ties (who were controversially paid o� at
par)? Or by trouble at its heavily regulated
insurance businesses? More than a year
later, no one seems sure.
Pricking bubbles�another mooted role
for systemic regulators�is also fraught

with danger. Many central bankers consid-
er it unrealistic to make prevention of as-
set-price bubbles a speci�c objective of
systemic oversight. But thinking at the Fed
has been shifting. Under Alan Greenspan
its policy had been to stand back, wait for
the pop and clean up the mess. But Ben
Bernanke, the current chairman, recently
backed the idea of intervening to take the
air out of bubbles. This could be done
mainly through stronger regulation, he
suggested, though he did not rule out mon-
etary policy as a back-up option.
Mr Mishkin, a former Fed governor,
draws a contrast between credit-boom
bubbles and irrational exuberance in
stockmarkets, such as the dotcom bubble.
The �rst is more dangerous, and the case
for pre-emptive action stronger, he argues,
because it comes with a cycle of leveraging
against rising asset values.
In retrospect all crashes look inevitable.
6Threadbare cushion
Banks’ capital ratios, %
0
5

10
15
20
25
1880 1900 20 40 60 80 2005
United States
Britain
�nancial risk 13
2
1
RISK antennae twitch after a crisis. Bank-ers, regulators and
academics, shaken
from their complacency, jostle to identify
the next tempest. Right now gusts are
blowing from several directions. Many
countries’ �scal positions are deteriorating
fast after costly interventions to shore up �-
nancial systems and restore growth. There
is talk of demanding collateral even on
deals with formerly unimpeachable sover-
eign entities. Recent terrorist incidents
have raised the spectre of external shocks.

Yet at least a fragile sort of optimism has
surfaced, born of ultra-cheap money and
relief at having avoided a depression. In
some markets fresh bubbles may be form-
ing. Stockmarkets have rebounded sharp-
ly. America’s, though still well o� their
peaks, are up to 50% overvalued on a his-
torical basis. Banks are once again throw-
ing money at hedge funds and private-equ-
ity �rms (though with tougher margin
requirements). Issuance of structured-loan
funds, which a few months back looked
dead, is booming. Investment banks’ pro-
�ts, and bonus pools, are back near pre-cri-
sis levels. International regulators have
been issuing warnings to chief executives
about a return of irrational exuberance.
Banks have been ordered to run stress tests
involving a sudden jump in interest rates,
in preparation for central banks’ with-
drawal of monetary adrenaline.
Many will already be doing this as they
try to show that they have learnt their les-
sons. Like the best chess players, bankers
insist that they are now concentrating as
hard on avoiding mistakes as on winning.
Those that sidestepped the worst mort-
gage-related landmines now top the indus-
try’s new order. Blackrock’s Mr Fisher de-
�nes risk as �deviation from objective�, on
the upside as well as the downside. If your
models tell you that a security is safer than
its returns imply, as with CDOs, that might
just suggest hidden risks.

Fancy mathematics will continue to
play a role, to be sure. But �nance is not
physics, and markets have an emotional
side. In their struggle with the quants,
those who would trust their gut instinct
have gained ground.
Learning to tie knots
Governments are taking no chances.
Bloomberg counts some 50 bills and other
serious proposals for �nancial reform in
America and Europe. Leaders in America’s
Senate hope to pass new rules by March.
But there are limits to what can be expect-
ed from regulators and supervisors. Like
bankers, they have blind spots. As the
mortgage �asco showed, they are vulner-
able to capture by those they police.
Their job will be made easier if new
rules tackle incentives for the private sec-
tor to take excessive risk. It is human be-
haviour, more than �nancial instruments,
that needs changing, says Mr Mauboussin
of Legg Mason. Like Odysseus passing the
sirens, bankers need to be tied to a mast to
stop them from giving in to temptation.
Pay structures should be better aligned
with the timescale of business strategies
that run for a number of years and should
not reward �leveraged beta�, unremark-
Blocking out the sirens’ song

Moneymen need saving from themselves
7Parti pris
Sources: Company accounts; Bloomberg; Benn Steil
Global asset-backed-securities issuance
and Moody’s profit per employee
0
0.25
0.50
0.75
1.00
1.25
0
50
100
150
200
250
2000 01 02 03 04 05 06 07 08
Total ABS issuance,

$trn
Profit per employee,
$’000
Even with the most insidious-looking bub-
bles, though, it is impossible to know at the
time how devastating the pop will be.
Many thought the economic fallout from
the internet crash would be far greater
than it turned out. The economic cost of
prematurely ending a boom can be high.
Even so, the worry is that a systemic regu-
lator would be biased towards interven-
tion, because it would face less criticism for
puncturing a non-bubble than for failing to
spot a real one.
Alex Pollock of the American Enter-
prise Institute (AEI), a think-tank, is con-
cerned that the creation of an o�cial sys-
temic regulator would bring false comfort,
just as the Fed’s founding in 1913 did. Ac-
cording to the then Comptroller of the Cur-
rency, it had rendered further crises �math-
ematically impossible�. Mr Pollock would
prefer to see the task go to an independent
advisory body, manned by economic
heavyweights to provide institutional
memory of past crises. For similar reasons,
Andrew Lo, director of MIT’s Laboratory
for Financial Engineering, suggests sepa-
rating regulation from forensics, as hap-
pens in the airline industry. America’s Na-
tional Transportation Safety Board is seen

as independent because its job is to investi-
gate crashes, not to set rules after the event.
That gives it more moral clout.
Whatever form it takes, systemic polic-
ing would face a problem. During booms,
governments are loth to take the punch-
bowl away, at least until the next election.
Nor do they want to be criticised for their
own contribution to systemic risk. They
may have become even touchier now that
they are, as Pimco’s Mohamed El-Erian
puts it, �market players as well as referees�.
A way round this would be to introduce
rules requiring the regulator to step in if,
say, credit and asset prices are growing at
above-average rates. That would shield it
from claims that the next boom is some-
how di�erent and should be left to run its
course. But it comes at the cost of �exibility.
All of this suggests that although there
is a strong case for a more system-wide ap-
proach to oversight, it could do more harm
than good if poorly crafted. Meanwhile
taxpayers will continue to underwrite �-
nancial giants; America’s reforms in their
current shape allow the authorities to pull
apart those that pose a �grave threat�, but
also to bail out their creditors if they con-
sider it necessary.
The danger is that the very existence of
a systemic regulator creates an illusion of

increasing stability even though it does the
opposite by strengthening the implicit
guarantee for the biggest banks�a �perma-
nent TARP�, as the AEI’s Peter Wallison
puts it. Too big to fail sometimes seems too
hard to solve. 7
13th 2010
2
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able returns juiced with borrowed money.
In securitisation, originators will have to
disclose more information about loan
pools and hold a slice of their products.
Some of the worst abuses in securitisa-
tion stemmed from the use of credit rat-
ings. Rating agencies systematically under-
estimated default risk on vast amounts of
debt, resulting in pu�ed-up prices and a
surfeit of issuance. Paid by issuers, they
had every incentive to award in�ated rat-
ings and keep the market humming: aver-
age pay at the agencies rose and fell in tan-
dem with the volume of asset-backed
issuance (see chart 7, previous page).
An obvious way to deal with this
would be to eliminate the agencies’ o�cial
�nationally recognised� status, opening
the business to unfettered competition.

Raters would then have to persuade inves-
tors of their competence, rather than rely-
ing on a government imprimatur. This, in
turn, would force investors themselves to
spend more time analysing loans. Oddly,
proposed reforms fall far short of this, with
no sign of anything tougher on the hori-
zon. CreditSights, a research �rm, awarded
ratings �rms its �Houdini was an Ama-
teur� award for 2009.
Nor, alas, is there much appetite to
tackle some of the public policies that con-
tributed to the crisis. The non-recourse sta-
tus of mortgages in large parts of America,
for instance, gives the borrower a highly at-
tractive put option: he can, in e�ect, sell the
house to the lender at any time for the prin-
cipal outstanding. An even bigger problem
is the favourable tax treatment of debt rela-
tive to equity. Phasing this out would dis-
courage the build-up of excessive leverage.
But the idea has little political traction.
There are, to be sure, risks to rushing re-
form. Post-crisis regulation has a long his-
tory of unintended consequences, from
the pay reforms of the early 1990s (when
new limits on the deductibility from cor-
porate tax of executive salaries merely
shifted the excesses to bonuses) to key
parts of the Sarbanes-Oxley act on cor-
porate governance. Another danger is the
pricing of risk by regulation, not markets.
The credit-card act passed in America last

year leaves providers with a choice be-
tween underpricing for some products,
which is bad for them, or restricting their
o�erings, which is bad for consumers.
Most would agree, however, that mar-
kets need both tighter rules and better en-
forcement. The biggest question mark
hangs over the fate of those institutions
whose collapse would threaten the sys-
tem. America’s proposal to cap banks’ size
and ban proprietary trading has forti�ed
those calling for radical measures to tackle
the �too big to fail� problem.
The virtues of scepticism
By itself, though, the plan does little to back
up Barack Obama’s promise to stop such
�rms from holding the taxpayer hostage.
Proprietary trading and investments are a
small part of most big banks’ activities and
played only a minor role in the crisis. Nor
does the plan cover brokers, insurers or in-
dustrial �rms’ �nance arms, all of which
had to be bailed out. To persuade markets
that the giants no longer enjoy implicit
state guarantees, whether they are banks
or not, policymakers will need to present a
cocktail of solutions that also include
tougher capital and liquidity standards,
central clearing of derivatives and credible
mechanisms to dismantle �rms whose
losses in a crisis would overwhelm even a
strengthened safety bu�er.

Together, intelligent regulatory reforms
and a better understanding of the limita-
tions of quantitative risk management can
help to reduce the damage in�icted on the
�nancial system when bubbles burst. But
they will never eliminate bad lending or
excessive exuberance. After every crisis
bankers and investors tend to forget that it
is their duty to be sceptical, not optimistic.
In �nance the gods will always �nd a way
to strike back. 7
The world has not learned the lessons of the financial crisis
Banks are safer, but too much of what has gone wrong since
2008 could happen again
WHEN historians gaze back at the early 21st century, they will
identify two seismic shocks. The first was the terrorist attacks
of September 11th 2001, the second the global financial crisis,
which boiled over ten years ago this month with the collapse of
Lehman Brothers. September 11th led to wars, Lehman’s
bankruptcy to an economic and political reckoning. Just as the
fighting continues, so the reckoning is far from over.
Lehman failed after losing money on toxic loans and securities
linked to America’s property market. Its bankruptcy unleashed
chaos. Trade fell in every country on which the World Trade
Organization reports. Credit supplied to the real economy fell,
by perhaps $2trn in America alone. To limit their indebtedness,
governments resorted to austerity. Having exhausted the scope
to cut interest rates, central bankers turned to quantitative
easing (creating money to buy bonds).
Just as the causes of the financial crisis were many and varied,
so were its consequences. It turbocharged today’s populist
surge, raising questions about income inequality, job insecurity

and globalization. But it also changed the financial system. The
question is: did it change it enough?
To splurge is human
One way—the wrong way—to judge progress would be to
expect an end to financial crises. Systemic banking meltdowns
are a feature of human history. The IMF has counted 124 of
them between 1970 and 2007. There is no question that they
will occur again, if only because good times breed
complacency. Consider that the Trump administration is
deregulating finance during an economic boom and that the
Federal Reserve has not yet raised counter-cyclical capital
requirements. Even when prudence prevails, no regulator is a
perfect judge of risk.
A better test is whether the likelihood and size of crises can be
reduced. On that, the news is both good and bad.
First, the good. Banks must now fund themselves with more
equity and less debt. They depend less on trading to make
money and on short-term wholesale borrowing to finance their
activities. Even in Europe, where few banks make large profits,
the system as a whole is stronger than it was. Regulators have
beefed up their oversight, especially of the largest institutions
that are too big to fail. On both sides of the Atlantic banks are
subject to regular stress tests and must submit plans for their
own orderly demise. Derivatives markets of the type that felled
AIG, an insurer, are smaller and safer. Revamped pay policies
should prevent a repeat of the injustice of bankers taking public
money while pocketing huge pay-packets—in 2009 staff at the
five biggest banks trousered $114bn.
Yet many lessons have gone unlearned. Take, for example,
policymakers’ mistakes in the aftermath of the crisis. The state
had no choice but to stand behind failing banks, but it took the
ill-judged decision to all but abandon insolvent households.
Perhaps 9m Americans lost their homes in the recession;
unemployment rose by over 8m. While households paid down
debt, consumer spending was ravaged.
It has taken fully ten years for the countervailing economic

stimulus to restore America’s economy to health. Many of
Europe’s economies still suffer from weak aggregate demand.
Fiscal and monetary policy could have done more, sooner, to
bring about recovery. They were held back by mostly misplaced
concerns about government debt and inflation. The fact that this
failing is not more widely acknowledged augurs badly for the
policy response next time.
Stagnation has, inevitably, fed populism. And, by looking for
scapegoats and simplistic solutions that punish them, populism
has made it harder to confront the real long-term problems that
the crisis exposed. Three stand out: housing, offshore dollar
finance and the euro.
To share divine
The precise shape of the next financial crisis is unclear—
otherwise it would surely be avoided. But, in one way or
another, it is likely to involve property. Rich-world
governments have never properly reconciled a desire to boost
home ownership with the need to avoid dangerous booms in
household credit, as in the mid-2000s. In America the
reluctance to confront this means that the taxpayer underwrites
70% of all new mortgage lending. Everywhere, regulations
encourage banks to lend against property rather than make loans
to businesses. The risk will be mitigated only when politicians
embrace fundamental reforms, such as reducing household
borrowing, with risk-sharing mortgages or permanent
constraints on loan-to-value ratios. In America taxpayers should
get out of the rotten business of guaranteeing mortgage debt.
Sadly, populists are hardly likely to take on homeowners.
Next, the greenback. The crisis spread across borders because
European banks ran out of the dollars they needed to pay back
their dollar-denominated borrowing. The Fed acted as lender of
last resort to the world, offering foreigners $1trn of liquidity.
Since then, offshore dollar debts have roughly doubled. In the
next crisis, America’s political system is unlikely to let the Fed
act as the backstop to this vast system, even after Donald Trump
leaves the White House. Finding ways to make offshore dollar

finance safe, such as pooling dollar reserves among emerging-
market countries, relies on international co-operation of the
type that is fast falling out of fashion.
The rise of nationalism also hinders Europe from solving the
euro’s structural problems. The crisis showed how a country’s
banks and its government are intertwined: the state struggles to
borrow enough to support the banks, which are dragged down
by the falling value of government debt. This “doom loop”
remains mostly intact. Until Europe shares more risks across
national borders—whether through financial markets, deposit
guarantees or fiscal policy—the future of the single currency
will remain in doubt. A chaotic collapse of the euro would make
the crisis of 2008 look like a picnic.
Policymakers have made the economy safer, but they still have
plenty of lessons to learn. And fracturing geopolitics make
globalized finance even harder to deal with. A decade after
Lehman failed, finance has a worrying amount to fix.
Debt is good for
you
Jan 25th 2001
From The Economist print
edition
Or so the theorists say

EVER since Franco
Modigliani and Merton Miller published their famous papers on
the relative
merits of debt and equity financing, the central question in
corporate finance
has been about the optimal balance between the two. Remember
that Messrs
Modigliani and Miller argued that, given certain assumptions,
the proportions of
debt and equity capital were irrelevant to the value of a firm;
the only
difference they made was to the distribution of the spoils
between creditors and
shareholders. This was because the more debt a firm issued for
a given level of
equity, the riskier that firm became. Leverage increases the
expected return to
shareholders, but it also increases their risks. In an efficient
stockmarket,
the two should cancel each other out.
But a later, modified
version of the Modigliani-Miller theory said something rather
different. It
allowed for the fact that the original assumptions, particularly
on taxation,
might not apply. In America, dividends are paid out of
companies’ net-of-tax
income, and are then taxed again in the hands of the recipients.
Interest
payments on debt, on the other hand, are tax-deductible. This
means that a
firm’s overall value should increase as it substitutes debt for

equity, and
suggests that many firms in the 1950s and 1960s had too much
equity and not
enough debt. However, it is clear that over the past couple of
decades they have
been trying to rectify that.
But not, perhaps, as
vigorously as might be expected. As Mr Miller cheerfully
conceded, his and his
colleague’s proposition implied that firms should be financed
almost entirely
with debt. Yet many big companies still think that their
weighted average cost
of capital—the total mix of debt and equity—would be cheaper
in the long term if
they maintained a solid credit rating.
Clearly, piling up more
debt benefits shareholders only up to a point. That point,
roughly speaking, is
reached when bondholders are so worried about the company
defaulting that the
cost of its debt rises to unsustainable levels. To go on
borrowing beyond that
point may even lead to bankruptcy—though note that
bankruptcy in America is
rather less onerous to shareholders than it is in many other big
economies.
Moreover, inflation, both in America and elsewhere, is much
less of a problem
than it was in the 1970s and early 1980s, so interest rates are
lower and
companies can afford to borrow more. Some commentators,
notably Stern Stewart, a
consultancy that does a lot of work in this area, maintain that
many firms still
have too little debt. Mature, profitable firms, with the least need

to borrow,
probably benefit most from doing so. Bond markets are a harsh
task-master: that
interest has to be paid.A matter of degree
Two other theories try
to explain why firms are still reluctant to incur debt, or at least
do not
borrow as much as implied by the Modigliani-Miller theory. The
first, called the
trade-off theory, says that the amount of debt a firm is willing
to take on
depends, among other things, on the business it is in. Profitable
companies with
stable cashflows and safe, tangible assets can afford more debt;
unprofitable,
risky ones with intangible assets, rather less. So dot.com
companies, to take a
formerly fashionable sector, would be ill-advised to shoulder
any debt at all.
Firms in highly cyclical industries, such as car making, should
probably be wary
of taking on too much. By contrast, utilities, whose business
tends to be more
predictable, can afford much greater leverage.
Managers prefer this
kind of theory to the Modigliani-Miller one because it does not
imply
categorically that they are doing the wrong thing. But does it
give them much
guidance on what, in fact, they should be doing? Some would
argue that in a way
it does; that firms “target” a credit rating they are happy with—
according to
the business they are in—and stick to it. Rick Escherich, an
analyst at J.P.
Morgan, has looked at a sample of 50 companies taken from

Fortune
magazine’s list of “most admired companies”, and found that
only four of
them have been downgraded by more than one notch over the
past ten years. Most
of them have the same rating now as they did a decade ago.
But Stephen Kealhofer of
KMV says that, according to his firm’s research, firms do
not target credit ratings, indeed quite the opposite: “We find
that firms engage
in anti-targeting behaviour.” Generally, they are more interested
in their
business plans than in what the rating agencies say. If they get
into trouble,
they increase their liabilities to enable them to carry out these
plans, as the
telecoms firms have done. “Only when they get close to default
do they reduce
them,” he points out.
Mr Kealhofer prefers a
third explanation of firms’ behaviour, dubbed “the pecking-
order theory”. The
central plank of this theory, first propounded by Stewart Meyers
in 1984, is
that outside investors in a firm know less about the health of a
firm than its
managers do. That can be a problem when the company wants to
issue equity:
investors may believe, rightly or wrongly, that the company is
doing this
because it thinks its shares are overpriced, and may respond by
selling them.
Issuing debt generally has a much less dramatic effect, but
external finance is
still costly. That is why the vast majority of new capital raised
by firms comes

from retained profits.
The pecking-order theory
might help to explain why many big firms hold large cash
reserves. If they find
that these are insufficient, they often take another route: to
delay paying
their bills. In effect, when they need to borrow, the first place
they look to
is their trade creditors. Only when that route becomes difficult
do they turn to
external lenders—ie, banks or the bond market—and only as a
last resort to the
equity markets. That helps to explain why companies with
stable profits often
borrow a lot less than unprofitable ones.
Yet none of these
theories gives much of a clue to whether, at any particular
point, firms’ debts
are too high or too low. To put it another way, they do not tell
you what the
market thinks of a firm’s default risk. For that, turn to another
theory, which
despite its less-than-snappy title has lately proved remarkably
powerful:
contingent claims analysis. This was first developed by Robert
Merton, an
economist who in 1997 won a Nobel prize with Myron Scholes
for his work on
developing mathematical models to price options (a third
collaborator, Fischer
Black, had already died). It uses option theory to analyse the
differing claims
that debtholders and shareholders have on a firm. The theory
says that
shareholders essentially own a call option on the firm (the right
but not the

Week 6 - Final Assignment Integrative Literatu.docx

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